Facebook, Running Out of Bodies, Is in Need of Major Reacceleration in Monetization Rates

Don't get me wrong -- I really, really want to like Facebook, but the more I look at the numbers, the more I doubt that ticker FB will make for a great investment.

Last June, I stated my concerns regarding Facebook's high penetrations rates in developed countries, which implied that much of the company's potential future growth was in less-lucrative emerging markets (see: Why a Facebook IPO Could Flop):

The latest rumors have Facebook bringing in $2 billion in operating income on $4 billion in revenue this year. Assuming these numbers are true, Facebook is bringing in about $8 for every active user.

The exact numbers don't matter. My concern is that since Facebook is increasingly reliant upon emerging markets for growth in the user count, that revenue-per-user number is going to drop over time. What may be $10 per user in the United States could easily be $1 in Bangladesh.

So while the user count could theoretically grow six-fold from here, the revenue base may not grow with it.

In this chart, we can see that Facebook's revenues have grown nicely along with the user base:

In the fourth quarter of 2011, Facebook had 845 million monthly average users, and generated $1.131 billion in revenues.

Not bad at all.

Now, here's a very basic revenue model for Facebook:

Revenue = Users X Revenue Per User

So let's look at the trend in the monthly average user count, along with year-over-year growth:

As you can see, Facebook is quickly approaching the 1 billion user mark, but growth has steadily slowed.

Now, let's look at how Facebook is monetizing each user. This chart shows quarterly revenue per monthly average user:

As you can see, over the past two years, Facebook has shown a nice improvement in revenue per user, but let's look at how the level of improvement is trending.

This table shows year-over-year growth in revenues per monthly average user:

As is evident, Facebook's ability to grow revenue per user hit a wall in the fourth quarter. And earlier, we showed that user growth is slowing dramatically.

Now why is this happening? Well, the user count slowdown can be explained very simply -- Facebook is just running out of bodies. There are only so many people on Earth using computers, smartphones, and tablets. I think we can all agree that this is expected.

As for the slowing growth in revenue per user, it's entirely likely that the late adopters are less lucrative than the early ones, particularly if the new folks are located in emerging markets where incomes are lower, making them less valuable targets for advertising campaigns.

And this is a problem because if Facebook can't expand its user base significantly, it must dramatically grow revenue per user in order to justify the $75-100 billion valuation that is being floated around.

In 2011, Facebook generated $3.711 billion in revenue, representing year-over-year growth of 88%. By the fourth quarter that slowed to 55%, consisting of 39% in user growth and 11% growth in revenue per user. Note the math: ((1+0.39)*(1+0.11)) -1 = 55%

So, I built a matrix detailing Facebook's potential future revenues under a variety of assumptions.

I assumed a variety of 2012 revenue growth rates, ranging from 35% to 55%, and assumed that the annual revenue growth rate declined by two percentage points in each subsequent year. So if Facebook grows at 35% in 2012, it slows to 33% in 2013, 31% in 2013, and so on.

Here's what that looks like:

For the sake of argument, let's say Facebook gets on track for $5.4 billion in revenue in 2012. Depending upon where the stock comes public, and how traders receive it at the outset, it could easily be trading at anywhere from 12 to 30 times 2012 sales.

And here's where the slowing growth becomes a big problem. As companies become more mature and their growth rates slow, their multiples tend to compress.

Let's look at Google's (GOOG) historical EV/Sales ratio since it came public in August of 2004:

(click to enlarge)

Google's revenues grew by 92% in 2005, and 117% in 2004. Currently, analysts are expecting Google to generate 22% revenue growth in 2012, and 28% 2013. The compressed valuation reflects that slowing growth.

You can see this trend in almost any tech stock.

For example, you'll hear Microsoft (MSFT) bulls complain that the company's trading at a lower valuation than it did a decade ago, despite the fact that revenues and earnings have more than doubled. Why? Because Microsoft is seen as being past its best years.

And keep in mind -- Facebook's revenue growth indicates that it is much more mature today than Google was in 2004, so it is doubly at risk of multiple shrinkage because it is later in its hyper-growth phase.

Now, what could go right?

People just might not care. They might buy Facebook regardless of the numbers, creating a momentum-begets-momentum situation. It's not out of the question.

More importantly, Facebook's growth in revenue per user growth could bounce back in the first quarter of 2012. That would send a signal that the slowdown in Q4 was a one-time blip.

Facebook has to kill it on this metric going forward because its addressable market is limited by the number of people using Internet-connected computing devices. And since Facebook will probably cross the 1 billion monthly user mark in the near future, again, it is running out of bodies.

But until we see that number turn around, I think the only big winners in the Facebook IPO are the folks that were smart enough to get in early, and Morgan Stanley (MS), which as the lead underwriter, will find itself perched comfortably at the top of the IPO league tables.

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